I started a few posts in draft mode, but neither was particularly upbeat for a Friday post (pension fraud, Puerto Rico and/or Chicago updates), but I just came across a sentence that made me smile:

This explains why the so-called “80% rule,” a frequently mis-cited rule of thumb that pension funds are safely funded so long as assets equal or exceed 80% of pension obligations, does not apply to pension funds that discount obligations at the same rate as they expect to earn on assets.

David Crane is a Lecturer in Public Policy at Stanford University, SIEPR Research Scholar and president of Govern For California. From 2004 – 2010 he served as a special advisor to Governor Arnold Schwarzenegger and from 1979-2003 he was a partner at Babcock & Brown, a financial services company. Crane also serves as a director of Building America’s Future, California Common Sense and the University of California’s Investment Advisory Group. Formerly he served on the University of California Board of Regents and as a director of the California State Teachers Retirement System, California High Speed Rail Authority, California Economic Development Commission, Djerassi Resident Artists Program, Environmental Defense Fund, Legal Services for Children, Jewish Community Center of San Francisco, Society of Actuaries Blue Ribbon Panel on the Causes of Public Pension Underfunding, and Volcker-Ravitch Task Force on the State Budget Crisis.

California’s retirement fund planners base their projections on returns that are higher than some experts predict.

SACRAMENTO — David Crane is a gifted investment banker who shared his expertise with government until he was dumped from a state board that invests teacher retirement funds.

Lawmakers bounced him from the board, one of the biggest players on Wall Street, after he repeatedly questioned whether state pension funds could earn enough to keep paying retirement benefits to teachers and other politically powerful employees.

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Lawmakers in June rejected Crane’s appointment to the teacher retirement board by Schwarzenegger, after he had served almost a year. State Senate leader Don Perata (D-Oakland) said the job of trustees is “only to protect members’ benefits” — not to worry about the long-term effects of the benefits on the state budget.

I think Crane had a point. Back in 2006, the discount rate was 8%. It’s 7.5% now. The 10-year annualized return was 6.9%. Not too far short of what was expected. But the difference adds up over the years.

Especially when your contribution history looks like this:

Crane definitely had a point about the long-term impact on the state’s finances. Given the state was already known to be short-changing the pension with regards to contributions, the state’s budget not being too badly impinged upon was key on making sure that the state really could pay the pension amounts.

Why do some defined benefit pension plans work well while others do not? The difference arises from choices made by pension fund boards. One critical choice is illustrated below.

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In contrast, compare the approach taken by the California State Teachers Retirement System (CalSTRS), which posts this statement in its most recent annual report:

You will notice that CalSTRS chooses to employ the same rate for both purposes. Using the same example as above ($100 due in 20 years) CalSTRS would record the initial obligation at only $24, 47% less than Berkshire would record the very same obligation. The balance ($76) would accrete into recorded liabilities over the next 20 years. Then CalSTRS would use the same 7.5% rate as its expected rate of return to initially set aside assets of $24. This has the following consequences:

Hidden liabilities. Even though teacher pensions are guaranteed by the State of California and a state may not discharge obligations through bankruptcy, CalSTRS’s board chooses to employ a discount rate more appropriate for a junk-level credit and one that is roughly twice the State of California’s discount rate. This has the perverse consequence of initially valuing a promise guaranteed by the State of California at a lower amount than a less valuable promise from a private-sector corporation and even below the value of other promises made by the same state. (The same promise of $100 due in 20 years in the form of a bond issued by the State of California would initially be valued closer to $50.) The choice of that discount rate masks the true size of pension promises until it’s too late. Citizens only learn the truth later when liabilities explode through growth at the high discount rate. Yet — as if living in a world scripted by Kafka —at that point citizens are also told that it’s too late to do anything about those promises.

Unsafely funded at anything less than 100%. Unlike Berkshire, CalSTRS may not claim it is safely funded at anything less than assets equal to 100% of liabilities. That concept applies only when the discount rate is less than the expected rate of return. This explains why the so-called “80% rule,” a frequently mis-cited rule of thumb that pension funds are safely funded so long as assets equal or exceed 80% of pension obligations, does not apply to pension funds that discount obligations at the same rate as they expect to earn on assets. When discount rate = expected rate of return, only 100% funding is safe.